How does a cash-out refinance work?

A cash-out refinance means refinancing your old home loan with a bigger loan, and taking the difference in cash. You can then spend that any way you want. So, naturally, you can use a cash-out refinance to buy a car.

Of course, this is an option only for those who are creditworthy, and whose homes are worth considerably more than their mortgage balances. But, if you live somewhere where prices have been rising, and you’ve been paying down your existing loan for some years, there’s a good chance you’ll qualify.

Cash-out refinance to buy a car — or pay off your auto loan

Vanishingly few financial advisors will tell you it’s a good idea to use a cash-out refinance to buy a car or to pay off an existing auto loan. Some may even call the notion dumb. Read on for the list of compelling reasons why they’re right.

However, personal finances don’t always work that way. For example, it’s dumb to use payday loans, right? Well, yes, if you’ve any choice.

But their high-interest rates might be worth paying if you can’t get to work because your car’s broken down and you’ve no other way to cover repairs. Similarly, payday loans can be cheaper than unauthorized overdrafts. Sometimes, when you’re desperate, the smartest (or only) move you can make is one you know to be “dumb” in normal circumstances.

Why it’s usually dumb

It’s time to look at those compelling reasons financial advisors will give you against using a cash-out refinance to buy a car. By far the most persuasive is cost.

It’s more expensive up front

Total interest payments on $20,000 released through 30-year cash-out refinance at 5 percent: $18,651

You’ll notice that it’s not higher interest rates that are killing you. You won’t get approved for a mortgage refinance unless your credit’s pretty good. So, especially with manufacturers’ and dealers’ incentives, you’ll likely be offered similar rates on both types of borrowing. Indeed, some auto loans come with lower ones than mortgages.

But, even if you don’t get a great deal, you’ll be worse off refinancing: an auto loan at double the rate (10 percent) will cost you “only” $5,496 in interest over the lifetime of the loan. That’s less than one-third what you’ll pay with that refinance. No, what kills you is that you’re borrowing the $20,000 for six times as long.

Payment (ancient) history

And that brings us to a second compelling reason. You’re borrowing over 30 years (360 months) to own a depreciating asset you’re likely to dispose of long before it’s paid for. A 2017 study by IHS Markit found that Americans on average keep their cars for 79.3 months (6.6 years). If you’re average, you’ll be making payments on your car for 280 months (over 23 years) after you’ve sold it.

Indeed, a 2014 report from IHS suggested the average age of a vehicle when it was scrapped was then 13 to 17 years. So you might expect to end up making payments for 156 to 204 months on a vehicle that has already been crushed into a cubic yard of mangled metal.

With luck, you’ll have completely forgotten by then that you used your cash-out refinance to buy a car. But, now you’ve read this, the thought may haunt you. Sorry about that.

Fees that hurt

Pretty much all cash-out refinances cost more than straightforward purchase mortgages or refinances where you don’t take cash out. Lenders see your need for cash as an added risk, so they cover that by increasing their charges.

This practice is called “risk-based pricing” or “loan-level pricing adjustments.” And your lender levies its fees on the amount of your new mortgage. So if you currently owe $200,000 and want to add $20,000 for your new car, you’ll pay an extra fee based on $220,000.

Depending on the risk factors you present, you may expect to pay, say, 2 percent of your total loan value in these fees. And on $220,000, that’s $4,400.

Paying $4,400 for an extra $20,000 is a lot (22 percent!) and may mess up the economics of your car purchase. Of course, you can probably add the $4,400 to your new mortgage balance. But then you’d be borrowing $24,400 to buy your $20,000 car — and that will bump up those interest costs even further (44 percent!!).

When it may not be dumb

The downside of borrowing money over a long period is that the interest you pay is going to add up. The upside is that you’ll be paying much less each month.

Much lower monthly payments with refinance

So, to revisit the same example used above:

Monthly payments on $20,000, 5-year car loan at 5 percent: $377

Monthly payments on $20,000 released through 30-year cash-out refinance at 5 percent: $107

If you have to pay 10 percent on your 5-year auto loan, the monthly payment will be $425.

Clearly, that minimum of $270 a month difference between a 5-year auto loan and a 30-year refinance will be critical to anyone currently facing serious cash flow challenges. Indeed, the more affordable option could see a family remain afloat and continue to pay its bills on time. The more expensive one could result in a financial spiral that ends in disaster.

Just drive a jalopy

The obvious response to someone considering using a cash-out refinance to buy a car or pay off an existing auto loan is: Don’t!

You’re considering spending more than $43,000 (the $20,000 you borrowed plus $18,650 in interest and $4,400 in risk-based pricing fees) just so you can impress your neighbors and stop your brother-in-law looking down his nose at you? That’s nuts.

Well, maybe. For sure, not many people would share your financial priorities. And it would be worth thinking them through again because there’s a good chance a day will come when you’ll regret your decision. But your choices are yours alone.

And, of course, some people genuinely need a car that brings prestige. Those who work in sales, for example, often have to maintain an image of success. Their living depends on it. Can you honestly say you wouldn’t view your real estate agent differently if she drove up to a viewing in a beaten-up Toyota that was built during the Clinton administration?

When you’re not just buying a car

The math can induce a slightly less severe migraine if your new car is part of a long list of essentials you need — and when your mortgage balance is low. Let’s add a twist to our earlier example.

Suppose you currently owe $20,000 (not $200,000) on your mortgage. But you need to borrow $200,000 on your cash-out refinancing, meaning you’ll end up with that same $220,000 loan balance.

You’ll still pay $4,400 in risk-based pricing fees because your lender calculates those on that balance. But you’ll be getting $200,000 rather than $20,000. And that means those fees will be 2.2 percent of your car’s cost rather than 22 percent.

The downside? You’ll have gone from having a negligible mortgage balance to a significant one. And you’ll face paying that down over the next 30 years. That list of essentials will need to be really essential to justify that. And it will have to mostly comprise “good” borrowing.

“Good” borrowing

Some people say there’s no such thing as “good” borrowing. But most probably differentiate between loans that are investments in your and your family’s future and those you use to prop up an unsustainable lifestyle that you can’t afford.

Here are some examples of what many would regard as “good” borrowing that could justify a cash-out refinance:

Unavoidable medical bills

College costs for you or your kids

Home improvements — especially ones that will at least eventually enhance the value of your property

Other investments — Providing you recognize that these come with risks, and are prepared to live with possible losses and perhaps with ongoing costs

Business startup — A different sort of investment that’s likely to carry higher rewards and higher risks

Debt consolidation — It can be good to pay down high-interest debt using a refinance. But you must first resolve to stick to a sustainable household budget or you’ll soon find yourself back at square one

Using a cash-out refinance to buy a car can be added to that list only if you have a genuine need for one and can’t pay for it any other way.

When “bad” borrowing is good

You might choose to borrow for things that aren’t financially sound but that provide you with sufficient pleasure to be worth the costs. It’s not “smart” to borrow for your child’s wedding or a once-in-a-lifetime cruise to celebrate a milestone anniversary.

However, with purchases like those, you’re expressing love and buying lifelong memories. Only you can decide whether the necessary loans are worth it.

The information contained on The Mortgage Reports website is for informational purposes only and is not an advertisement for products offered by Full Beaker. The views and opinions expressed herein are those of the author and do not reflect the policy or position of Full Beaker, its officers, parent, or affiliates.